Exploring complex world of bank directorship

Whether a director is new or experienced, succinct information about the actual functioning of the regulated banking business and the actual application of the directors’ legal duties establishes the context for directors’ decisions. This information is even more germane now because of the increased regulatory scrutiny of the banking business.

The Ultimate Guide for Bank Directors, by Catherine A. Ghiglieri and Jewell D. Hoover, appropriately identifies this real need; unfortunately, the guide falls short of filling this need.

 

The authors are former bank regulators and co-founders of The Bank Directors College. According to its foreword, the guide provides “a wealth of insight, including ‘best practice’ guidance gleaned by the authors during their many years as bank examiners.”  The guide’s lessons learned from experience are, in fact, valuable.

Boards of directors are collegial bodies, and boards ensure their legal, business, and other authority when they function well. Thus, practical advice that enhances the functioning of a board materially benefits not only the board itself, but also the bank and its shareholders and regulators. For example, the guide provides a checklist of simple improvements gleaned from the authors’ observations over years of observing board performance. These improvements are widely acknowledged as cumulatively enhancing boards’ effectiveness, and are consistent with my own conclusions based on years of serving on and working with boards. To wit:

• Board chairs should be independent from the president/CEO.

• Board books should be distributed in advance to allow time for meaningful director review.

• Board book topics should change over time to include information relevant to current issues. More importantly, other information should be removed.

• Boards should hold executive sessions--where management is asked to leave the room to ensure free discussion--at every meeting.

• Boards should at least annually evaluate the board and committee performance.

• Boards should have between 9 and 11 members to adequately staff committees while simultaneously allowing effective decision-making.

• Board members should be trained in director duties.

 

Those are all good points. Unfortunately, when the authors stray from their experience, the quality--and sometimes the accuracy--of the advice rapidly deteriorates.

These errors are readily apparent when the guide reviews the legal duties of directors. For example, the book correctly identifies the fundamental duties of care and loyalty as two common formulations of a director’s responsibilities. However, it incorrectly describes the duties and errs in their application.

The guide asserts that the duty of care requires, among other essentials, that directors set an “appropriate tone at the top” and then claims that “tone at the top” is a term from the Sarbanes Oxley Act of 2002.

However, the phrase “tone at the top” never appears in the Sarbanes-Oxley Act, and, more fundamentally, the Sarbanes-Oxley Act does not legislate regarding the duty of care. The Sarbanes-Oxley Act is a federal statute; duty of care is a long-standing state common-law doctrine.

In another example, the guide asserts that the duty of care requires a director to “exercise the same level of care in making decisions for the bank that an ordinary person would use in making their own personal or business decisions.”  (See p. 26.)  On the contrary, the duty of care requires a director to exercise the same level of care as a person in a similar position (that is, another bank director) would exercise in similar circumstances (that is, similar banking situations).

The difference in expectations between (i) that of an ordinary person and an experienced bank director, and (ii) personal situations and banking situations, is significant.

In my role as a bank director, my peer groups for determining the appropriateness of my actions are other bank directors sitting in my chair and confronting the same circumstances that I confront. My peer groups are not lay citizens determining how to best spend their money or pay for retirement.

An investment risk that may seem excessive to an ordinary citizen contemplating retirement may be very reasonable for a bank director considering opening a new branch during a recession.

 

The guide also misstates the role of the business judgment rule, which is a rule of judicial interpretation governing the application to specific situations of the duties of care and loyalty.

The business judgment rule has several formulations, and is commonly stated as a presumption that directors act in good faith and in the best interests of the business. The underlying notion is that courts make legal, and not business, decisions, and that directors are not legally liable because of business results, but only legally liable if directors violate the applicable legal processes.

As an example, a business strategy adopted by a board that ultimately bankrupts a business will not trigger legal liability for the directors as long as the board complied with the legal processes when adopting the strategy, and directors have considerable flexibility in compliance.

An essential aspect of the rule is that it is a “presumption,” which means that a court simply presumes a director acted properly unless proven otherwise. In practice, this presumption is extremely valuable, because it reinforces the legal notion that courts will not second-guess business decisions.

However, the  guide’s discussion of the business judgment rule is misleading. The guide asserts that the business judgment rule “emerged in case law in the 1980s when there were a large number of bank failures and the FDIC instituted civil lawsuits” and provides “that the FDIC will not second guess the soundness of bank director’s decisions.”  (See p. 27.) 

On the contrary, the business judgment rule far antedated the banking crises of the 1980s, and, more importantly, applies to the directors’ performance of their duties of care and loyalty owed to the corporation and its shareholders, and does not apply to the duties that directors owe to the FDIC.

The business judgment rule affects FDIC claims against directors only when FDIC, as receiver, steps into the shoes of the failed bank corporation and sues directors in the name of and on behalf of the banking corporation and its shareholders. The business judgment rule will not protect directors from violations of duties directly imposed by the FDIC’s governing statutes and regulation.

 

The guide’s discussion of the law relating to directors also highlights another weakness. At times, the guide focuses on legal requirements and practices applicable to large or publicly traded banks, and implies that these requirements and practices apply to all banks. For example, the guide states that a board should have a majority of independent directors, and then lists the elements that determine the independence of directors of companies listed on the New York Stock Exchange. (See p. 24.)  These standards apply to all companies that are traded on the Exchange, and not merely to banks. These standards do not apply to community banks that are listed, for example, on another stock exchange such as NASDAQ; do not apply banks that are traded on the pink sheets; and do not apply to privately-owned banks.

Yet the book never cautions that the independence standards set forth in it apply to only a very limited number of banking institutions. In addition, and more importantly, omitted is any mention of the director independence rules that do apply to all banks, regardless of whether or where their shares of stock are traded.

FDIC requires that all banks, regardless of size, have audit committees, and that certain of the audit committees have directors that are independent according to the comprehensive standards promulgated by the FDIC. (See 12 C.F.R. § 363.5 and Appendix A, Guideline 28.)

As a director of a community bank, and a lawyer advising directors of community banks, my focus is to comply with director independence standards that are promulgated by the FDIC and that apply to my board. If I followed this book, I would follow the wrong rules.

 

If directors desire a short lay summary of their duties, there are better and more accurate sources of information.

The best lay summary of board member legal duties is the Corporate Director’s Guidebook, published by the Committee on Corporate Laws of the American Bar Association. It is now in its Sixth Edition, published in 2011. I frequently provide copies of this short, readable book to directors and receive many favorable comments.

A concise manual focusing on bank directors is BASICS FOR BANK DIRECTORS, published by the Federal Reserve Bank of Kansas City, last updated in 2010 and now in its Fifth Edition, and available electronically for free here.

Although slightly longer and more technical than the guide, Basics covers almost all the same topics as the guide; is more comprehensive and accurate in its description of the applicable law and banking regulations; and has the benefit of applying the law in the context of a bank director.

 

OTHER SOURCES

• ABA offers director and trustee education and training in several formats. Click here for a compilation

• Bank Directors Briefing brings board members insights on directorship plus coverage of Washington issues and banking business trends. For a free sample copy, email Steve Cocheo, editor.

 

 

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